How should one design their hedge fund portfolio? Perhaps, there is an ideal season for each hedge fund strategy.

For example, good macro funds, by virtue of predicting macro events correctly, are supposed to perform better than other funds during periods of high macro risk. These are also periods characterized by high pair-wise correlations among stocks. Such high co-movement among stocks creates a difficult environment for stock pickers and long-short equity funds. In addition, markets can move in a swift and dramatic fashion magnifying any weakness in risk management or unintended exposures. In 2011, many long-short equity funds were caught in precisely such a dynamic.

When macro risks are low, company specific fundamentals and news are once again important drivers of returns. Stocks no longer move as one big basket. Not surprisingly, this provides an ideal backdrop for stock pickers who can distinguish good stocks from bad stocks. The higher dispersion among different types of stocks in turn translates into higher returns and good long-short equity funds perform better than their counterparts.

Which Season?

As signs of normalization are returning to markets, long-short equity managers are being viewed favorably again. Some market watchers are drawing similarities between the current environment and 1994, or 2003, when bonds sold off, rates increased and many hedge funds began what was to be an impressive run.

Yet, there are others who view these signs of normalization as treacherous. They point to unknown risks of unprecedented monetary policy, as well as to the emanating tremors in emerging markets. They fear the repercussions when the injected liquidity is inevitably withdrawn, or if the liquidity is not withdrawn in a timely manner.

These divergent views reveal the uncertainty that we face. Much like the global weather patterns, our financial markets are prone to unpredictable bouts of various seasons – now more than in past cyclical upturns. So, even as there may be an ideal strategy for each season, there is another increasingly important question - what season should the hedge fund allocator design their portfolio for?

Many allocators are responding by beginning to emphasize portfolio fit. They want to be equipped for different seasons – with a strategic tilt towards the season they think they are in.

One must not only consider the best strategy for each season but also how this “best strategy” performs during sudden season changes. Among different strategies that do well in a particular environment, which ones are most robust to a change in that environment?

Portfolio Fit – An Example

Take for example, transition periods when the macro risks go from low to high triggered by market realization of a lurking risk such as “tapering risk”. These transition periods are difficult for many strategies. Trend following funds perform best when trends continue, not when they suddenly change. Typical long-short strategies also perform poorly when macro risk increases – mostly since reward for stock picking skill evaporates and market drops cause losses due to exposures such strategies have.

In this environment, an investment approach that combines rigorous risk management with a stock selection process (“Portfolio Fit Strategy”) can be a valuable addition to a hedge fund portfolio. Using stock selection themes to sift between attractive and laggard stock picks (rather than traditional quant factors) allows the strategy to benefit from a low macro risk environment in much the same way that long-short equity funds do.

On the other hand, rigorous risk management results in a diversified strategy that avoids typical exposures to markets and other hidden factors. This in turn helps the strategy preserve its alpha even in a high macro risk environment and preserve gains in environments that go from low to high risk. Examples of such an investment approach include multi-strategy equity funds, platforms that combine fundamental and systematic funds, deep value strategies that utilize cash as an aggressive risk management tool, or a systematic process applied to traditional long short equity.

An allocator who is designing his portfolio in a low risk season should want to add strategies that do well now but that can also hold their own if the season goes from low to high risk. A Portfolio Fit Strategy has this essential property. In the table below, a strategy such as this becomes the best portfolio fit solution.

High Risk Environment

In a high macro risk environment, a good macro fund and a Portfolio Fit Strategy are both likely to perform well. However, an environment when risks go from high to low is potentially unfavorable for such funds because they have no exposures to the rising market that typically accompanies this drop in macro risk.

In addition, the first leg of such a reduction in macro risk is often driven by a drop in pairwise stock correlations due to sector dispersion rather than due to intra-sector dispersion. For example, in January 2012, pairwise correlations among stocks dropped significantly (it was the largest drop in at least the last 10 years) but correlations among stocks within a sector were still high. Utilities were down, financials were up, with very little to choose among utilities or among financials. So a sector neutral stock picking strategy, such as a Portfolio Fit Strategy, still had no room to perform. This feature makes a Portfolio Fit Strategy a second best solution when observed risks are high – the best being a good macro fund (one that avoids trend following approaches).

From a portfolio fit approach, a Portfolio Fit Strategy addresses a valuable need. In an environment characterized by low macro risk, a Portfolio Fit Strategy stands out. In an environment characterized by high macro risk, a Portfolio Fit Strategy might be a second best solution, but still superior to other long-short equity funds. Taken together, a Portfolio Fit Strategy can be an integral and durable part of a well designed hedge fund portfolio that seeks to deliver in all seasons.

Dr. Vinay Nair is the Managing Partner and CEO of Ada Investments, an investment management company focused on providing liquid solutions to institutional and private clients globally. Ada's investment philosophy centers on the belief that fundamental research ideas used to select securities can be evaluated using empirical techniques and executed through a disciplined rules-based approach. The firm has offices in New York, NY and Mumbai, India. Before founding Ada, he was the Research Director and a Portfolio Manager at Old Lane (Citi Alternative Investments).